After the Reform of Banking Regulation: Has the Financial System - - PowerPoint PPT Presentation

After the Reform of Banking Regulation: Has the Financial System Become Safe?

Amsterdam, June 12, 2014

MPI Collective Goods Martin Hellwig

Safer is not safe

• Since 2008, the financial system has become

safer, but safer is not the same as safe

• If all the new regulations had been in place in

2000, would the crisis have been avoided?

• No!
• A truck explodes in a tunnel at 150 km/h
• We lower the speed limit to 140 km/h
• ... And we impose a limit on gas consumption
• f SUVs
• Has the tunnel become safe?

• „Basel III“= „Basel 2.01“
• No reform of the model based approach
• Changes in quality of „capital“ – ABE?
• A tripling of something close to zero ...
• Leverage ratio 3 % of total assets...
• Macroprudential regulation ... A new form of

fine tuning?

• Liquidity Coverage Ratio ... diluted ABC principle

(Anything but cash!)

• Net Stable Funding Ratio, yet to be introduced

Reforms since the Crisis

Reforms since the Crisis

• New Organizations: EBA, EIOPA, ESMA, ESRB,

…

• As if the crisis had been caused by lack of European

integration

• New rules for hedge funds,
• As if the crisis had been caused by hedge funds
• Prohibition of short sales
• As if short sales had caused the disaster at Lehman

Brothers or Hypo Real Estate

Reforms since the Crisis

• Financial Transactions Tax
• As if the crisis had been caused by stock market

speculation

• Structural Reform (Volckers, Vickers, Liikanen)

As if deposits were the only thing that might require a bailout

• Restructuring Levy and Funds
• As if this would pay for future bailouts
• Improvements (?) in recovery and resolution:

UK, D, US, EU ... Not practical and ineffective

Resolution? Unsolved Issues

• Cross-border banking with systemically important

acitivities in different countries: Lehman Brothers, Deutsche, BNP Paribas, Barcleys

• Funding: Money market funding and derivatives

need to be maintained – how?

• Bail-Ins? Legal uncertainty
• Fiscal backstops?
• Procedures?
• WE NEED PREVENTION

„The Bankers New Clothes“ Main Message

• Equity requirements are key.
• Banks should be forced to fund with much

more with equity than they currently do, i.e., borrow relatively less and use relatively more

• f their own funds
• Equity requirements should NOT be calibrated

(downwards) to account for purported differences in asset risks

• Proposal: 20 – 30 % of total assets (no

netting)

Assessment of the Crisis

• The crisis has not one cause, but several
• Bad Loans: Real estate, sovereign
• Excessive leverage and maturity

transformation

• Excessive Interconnectedness
• Flawed financial system architecture

generating a downward spiral based on the interplay of asset price declines, fair-value accounting, inadequacy of bank capital, deleveraging, asset price declines….

A brief overview over the crisis

• Buildup of risks: Subprime lending and

securitization

• August 2007 – Downgrades of AAA rated

securities by several grades at once

• August 2007 – Breakdown of ABCB funding of

conduits and SIVs (Gorton‘s „panic of 2007“ – except that it wasn‘t repo and the SIV‘s were taken into their parents‘ balance sheets)

A brief overview over the crisis 2

• August 2007 – Capital squeeze:
• Taking SIVs into the parent‘s balance sheet implied a

capital squeeze of the parent

• ... In some cases insolvency from writedowns on the

SIVs assets

• August 2007 – September 2008:

Deleveraging, asset price declines, writedowns, further fire sales

• Not a panic but a slow implosion
• Several breakdowns of interbank markets,

smoothed by central banks

A brief overview over the crisis 3

• March 2008, September 2008: Funding

breakdowns at Bear Stearns and Lehman Brothers, driven by repo runs on these banks, which had been exposed to the risks of subprime assets that they had been unable to sell.

• September 2008: Post Lehman: Contractual

dominos, runs on money market funds, runs by money market funds, enormous asset price declines...

Liquidity versus solvency narratives

• Liquidity narrative: The crisis was due to a

breakdown of confidence, final assets were not doing so badly, uncertainty as to where the problems were led to exagerations, defensive reactions etc.

• Solvency narrative: Losses on final assets were
• substantial. Because everybody had borrowed a lot

(97% of balance sheets), many institutions were (and probably still are) insolvent. The liquidity breakdowns were a reaction to realizations that borrowers were insolvent.

Both are right

• There were extensive losses and extensive

insolvencies

• The breakdown did take the form of liquidity

breakdowns

• Some of the defensive reactions may seem

excessive

• But were they?

Insufficiency of Bank Equity I

• Practically no “Free” equity
• Write-Downs induce an immediate need for

corrective action

• Corrective Actions:
• Recapitalization
• Deleveraging
• Deleveraging enhances sales pressures in

markets, lowers market prices even further

• Induces further write-downs at other banks,

etc.

Insufficiency of Bank Equity II

• With equity amounting to 1 - 3 % of

unweighted assets, two problems arise:

• Multipliers for Deleveraging are exorbitant
• There quickly are problems with solvency
• Doubts about solvency endanger funding
• „Runs“ Problem
• Examples:
• Bear Stearns, Lehman Brothers
• Europe in 2011

Deficits of Regulation and Supervision

• Intransparency about system exposure to risk
• Excessive leverage, maturity transformation,

liquidity assistance promises,

• Insufficiency of bank equity under the model

based approach

• Procyclicality of deleveraging induced by

regulation

Reasons for these Deficits

• Anti-regulation stance of governments,

ideology of “national champions”

• Fear of regulators to invoke the second pillar
• f Basel in order to forbid excessive maturity

transformation etc.

• Political Economy (German Landesbanken)
• Lack of Conceptual Foundations for regulation

as a basis for capture

Prehistory

• 1988 Basel I: 8 % equity requirement for

(ordinary) credit risks

• 1993: First Proposal for equity requirements

for market risks (Standard approach)

• 1993-1995: Regulatory Capture by

Sophistication: “We understand much more than you do about risk management and risk control”

• 1995: Revised Proposal for equity

requirements for market risks (Standard Approach + model based approach)

• 1996: Amendment of Basel I for Market risks
• 1996 – 2005: Discussion about Basel II

Critique of the Model Based Approach 1

• Model Based „Economizing on equity capital“

has been a reason why solvency became an issue so quickly

• 10 % “Core Capital” or 1 – 3 % of the balance

sheet – which number is more meaningful?

• … in the crisis, we have seen the realization of

risks that had not been accounted for in the models!

Critique of the Model Based Approach 2

• … Correlations of MBS due to a common

dependence on the same underlying factors (Interest Rates, Real Estate Prices)

• … Correlations between counterparty credit

risks and underlying risks in hedge contracts

• … system risk exposure due to excessive

maturity transformation and leveraging at investment banks, conduits, etc.

Critique of the Model Based Approach 3

• These deficits are fundamental:
• Time series are nonstationary, some of them

much too short to provide a reliable basis for statistical analysis (contrast the papers of the Basel Committee on Backtesting!)

• Credit risks are endogenous
• … and change over time … unobservably
• Correlations of underlying and counterparty

credit risk can hardly be measured

• Incentives for better models are missing

A Cynical Interjection

• Risk-based capital regulation treats sovereign debt

as riskless

• Funding risks of loans in the bank book are
• verlooked
• Correlations between credit risks in the bank book

are overlooked

Conceptual Deficits Facilitate Capture

• “… surely you agree that a system of capital

regulation with risk calibration is better than

• ne without“
• Conceptual deficits induce helplessness in the

face of such statements

• If only I knew what capital regulation is

supposed to be doing!!!

Conceptual Deficits of Bank Capital Regulation

Four Deficits:

• The objectives of capital regulation are not

specified

• … nor is there an account of how the

regulation will serve those objectives

• Neglect of the dynamics of regulation
• Neglect of systemic interdependence

Conceptual Deficits of Bank Capital Regulation: Objectives

What is the purpose of capital regulation?

• Equity as a buffer against losses
• Equity as an incentive mechanism to reduce

gambling for resurrection

• Equity requirements as a basis for supervisory

intervention in advance of an insolvency

• All three aims are usually mentioned, but

conflicts and tradeoffs are not discussed

Conceptual Deficits of Bank Capital Regulation: Objectives

• BCBS 180:
• Regulatory Minimum: The amount of capital a

bank needs to be regarded as viable by creditors and counterparties

• Buffer: The amount needed to withstand

shocks so that they do not go below the regulatory minimum.

• No notion of externalities
• No notion of endogeneity of creditor attitudes

Conceptual Deficits: Dynamics

• All theoretical arguments come from a two

period model with financing and investment decisions in period 1 and returns coming due in period 2.

• In such a model, equity capital is a buffer and

reduces incentives to gamble

• What are the effects of capital regulation in a

multi-period world?

Conceptual Deficits: Dynamics

• In a multi-period world, capital requirements

are not just imposed ex ante, but also ex interim, after the bank has acquired a history and when it is sitting on previously acquired assets.

• How is the regulation applied ex interim? E.g.

what are the dynamics of reaction to intervening losses?

• Practice: Requirements must be satisfied at

each instant!

Conceptual Deficits: Dynamics

• Paradox of Regulation: Regulatory capital does

not serve as a buffer because it is needed to satisfy the regulator.

• Without “free” capital, one must react to

losses by recapitalizing or deleveraging

• In malfunctioning markets, sales of assets

below discounted present values of returns harms solvency!

• Why is there no discussion about the dynamics
• f adjustment after losses ?

Conceptual Deficits: Dynamics

• Paradox of Regulation: In an intertemporal

setting, the anticipation of future capital requirements can enhance risk taking incentives

• Heads, I win and have additional equity and

can grant 12.5 times (50 times?) that many more loans

• Tails, the taxpayer/depositor loses!

Conceptual Deficits: Systemic Interdependence

• Banking Regulation and Supervision neglect

systemic interdependence.

• Focus on the individual institution (the target
• f the underlying legal norms)
• However: In the past twenty years there have

been many instances where all banks satisfied regulatory requirements and suddenly there was a banking crisis!

Conceptual Deficits: Systemic Interdependence

• The notion that you can control solvency risks

by looking at each individual institution in isolation neglects the problems that arise from correlations of underlying and counterparty risks, from system risk exposure to the behaviour of others, finally also the problems that stem from the insufficient empirical basis for measuring correlations

Conceptual Deficits: Systemic Interdependence

• When considering corrective actions, system

interdependence is also neglected

• If all banks have problems at the same time,

e.g. because of common exposure to an interest rate shock, corrective actions occur simultaneously and must affect market prices

• Deleveraging depresses market prices and has

negative effects on the solvency of other institutions!

Systemic Risk and Macro Risk

• Systemic Risk:
• Risk to the system due to common exposure?
• Risk to the economy from the system?
• Risk to the system from systemic interdependence?
• Systemic Interdependence:
• Information contagion
• Dominos through contracts and loss of contracting
• pportunities
• Dominos through fire sale effects on asset prices
• Loss of market making functions

Systemic Risk and Macro Risk

• Protection against macro risks by hedging
• ... Can just be a way of moving these risks

elsewhere

• …. to possibly get them back through

correlated counterparty risks!

• Examples: UK interest rates 1990, Thailand

1997, AIG/monoliners 2008

• Enhancing exposure of others?
• Hiding risks in correlations?

Conceptual Deficits: Systemic Interdependence

• Macroprudential elements to capital regulation

are welcome but should not be based on illusions about our ability to measure

• As yet there is no theoretical or empirical

analysis of what the effects of the regulation are or will be

• Such an analysis requires concepts of general-

equilibrium theory (not just risk management methods!) in order to encompass changes in markets.

Conceptual Deficits: Systemic Interdependence

• “… surely you agree that a system of capital

regulation with risk calibration is better than one without“

• Lecture BoE 2000: “Of course the proposed system

for Basel II is much better than Basel I …. just as the Soviet Union’s five-year plans under Breshnev were much better than under Stalin!”

• They talk about higher equity requirements for

riskier positions and mean lower equity requirements for positions that they claim are not risky.

Our recommendation

• Equity = 20 – 30 % of total assets would reduce

deleveraging multipliers

• Risk weighting only to be used to raise the

requirement

• ... As well as solvency suspicions
• ... And thereby reduce liquidity risks.
• At this equity level, implicit subsidization of banks

through (unspoken, but effective) government guarantees would play a smaller role

• Moreover, liability of decision makers for the

consequences of their actions would be better

What do we mean by „20 – 30%“

• Move to a system of graduated interventions:
• No payouts below 30 %
• Recapitalization below 20 %
• Accounting issues: Derivatives, Asset valuations,

etc.

• Role of market values: legally problematic, but

very relevant information

• .... Except: market values may be inflated by the

default option

Bankers New Clothes 1

• „A dollar in capital is a dollar not working in the

economy“

• Confusion: Equity – Cash Reserve
• What is „equity“?
• Kate makes a downpayment of $ 30.000 on a $

300.000 house – equity .... Not cash!

• Leverage effects: If the value of th ehouse goes up

by 10 %, Kate earns a return of 100 % of her equity

• … and if it goes down by 10%?
• How big is the leverage effect at 3 % equity?

Bankers New Clothes 2

• „Equity requirements lower bank lending and

growth“

• And the fourth quarter of 2008???
• If equity today is fixed and given, a higher equity

requirement today lowers bank lending today

• („Banks are where the money is“!)
• ... but reduces the banks‘ exposure to losses next

year and raises banklending next after losses next year

• Requirement smoothes the time path

Bankers New Clothes 3

• „If equity requirements are doubled, bank lending

is cut in half“

• Bank lending or investments in toxic securities?
• Assumption: Equity is fixed and given.
• If the bank is profitable, it can retain earnings or

issue new shares.

• … but it does not want to do that because

shareholders would suffer

• … as some of the benefit goes to creditors and

taxpayers

Bankers‘ New Clothes 4

• „Where would all this equity come from?“
• If banks issue equity and use the proceeds to buy

shares and other securities, the sellers of those securities get cash.

• No more than a realignment of securities
• wnership patterns
• ... As with the appearance of a stock fund

Problem of transition

• And if banks are unprofitable?
• Europe has too much banking capacity
• Evidence: In some markets (wholesale, covered

bonds) you cannot make money unless you gamble (Dexia, Hypo Real Estate, Landesbanken, Investment Banks)

• Europe has too many zombies; losses from real

estate, government, shipping loans still hidden

• Zombies use ECB money to fund governments and

to speculate in markets, little lending

• A cleanup is needed

Bankers‘ New Clothes 5

• „Higher equity requirements will raise the funding

costs of banks because the required return on equity is higher than the required return on debt“ “

• The difference in required returns reflects a

difference in risks.

• With more equity, the return per $ in equity is less

risky and the required rate of return is lower

• Under some conditions, funding costs are

independent of the funding mix

• ... Except that higher equity might reduce

subsidies from taxpayers

Bankers‘ New Clothes 6

• „Higher equity requirments harm shareholders by

lowering ROE“

• ROE - Return on Equity is a random variable
• If the realization of ROE is low, the sentence is

false.

• Average ROE is likely to go down but so is risk!
• ROE does not measure performance unless you

correct for leverage and risk

• Incentive systems that are based on ROE induce

gambling and fraud (mark-to-model, LIBOR)

Shareholders‘ Interests

• Higher equity requirements harm shareholders by

reducing taxpayer subsidies

• Debt Overhang Effect: Shareholders also dislike

„dilution“ from new shares if the new money benefits creditors by making the debt safer

• A higher equity requirement in the form of a ratio

provides them with incentives to sell safe assets in

• rder to reduce junior debt, which makes

incumbent senior debt holders pay part of the cost (Europe 2011/12)

• Distinction social versus private costs

Bankers‘ New Clothes 7

• „We cannot have stricter regulation than others –
• r our banks will suffer in global competition“
• It would have been good for German or Swiss

society if German banks or UBS had been less „competitive“

• Competitiveness on the basis of government

subsidies and guarantees is economically harmful

• The global economy is unlike the olympics
• No national interest in the „competitiveness of our

banks“ – only in the proper use of resources

• Are all those physicists in banks well used?

„Competitiveness“ and subsidies

• If competitive success of banks is due to their

imposing costs on the economy, should we admit that just because banks elsewhere are allowed to do the same?

• If a chemical company pollutes a river, ....

Should we admit that just because its competitors in Delaware are allowed to pollute?

Why regulation?

• Banking regulation is necessary to reduce the

fallout from risks in banking on the rest of the economy

• … risk for payments infrastructures, market

making infrastructures

• … costs for taxpayers
• … costs for the economy
• Equity requirements improve liability
• … and reduce bank vulnerability
• .... and systemic feedback effects

Reform of Regulation

• We must get away from the idea that risk

control in the interest of banks and risk control in the interest of the public are the same thing

• We need elements of regulation that do not

rely on banks‘ having got their risk models right.

• We need to reduce or eliminate adverse

systemic effects of regulation as well as bank behaviour.